Gilt market gyrations make the case for Threadneedle's absolute return strategy

We suggested that Gilt yields were below rational expectations relative to other asset classes; but continuing structural demand was set to continue for some considerable time unless the regulations on capital adequacy were reviewed.

In a nutshell, pension fund deficits are calculated using long-dated bond yields. Low yields reduce the discount rate used to calculate future returns on assets. If, as in Japan, yields were zero, then there would be no way that pension funds could make good any deficits and the sponsoring company would be forced to put capital into its pension fund.

This means that as real yields fall, deficits grow larger. Pension funds are thus forced to buy more bonds, creating a vicious spiral. The yield on the 50-year index-linked has fallen dramatically in recent trading days. Last week, a surge of demand sent its real yield to a record low of 0.38 per cent.

The impact of the pension crisis-inspired bubble in the gilt market was clearly shown yesterday when the government auctioned inflation-linked bonds at the lowest yield ever.

The Debt Management Office, which manages borrowing on behalf of the UK government, sold £650m at par value of 50-year inflation-linked bonds at a yield over inflation of just 0.46 per cent. That is the lowest ever.

Quentin Fitzsimmons, manager of Threadneedle’s Absolute Return Bond Fund, believes the turmoil in the gilt market clarifies the case for his new product. “We have the ability to go short as well as long on this fund – although not net short. We have been anticipating that the yields on long dated gilts would continue to fall – even though they have looked expensive for a while. However, tactically we can take short positions from time to time when we believe that prices will fall back a little. So our investors can benefit from any volatility in either direction.

I should emphasise that the fund invests in a range of instruments and strategies as well as taking positions in the gilt market. However, conventional gilt investors might like to ponder on the problem that they are now getting very low yields and increased volatility. That’s less return and more risk – not a great formula.”